Thursday, December 18, 2008

Sovereign(age) Default

With mounting debts, high current account deficits, and an angry population carrying a lot of private debt, the U.S. monetary and financial authorities are squirming. For a while, I've been predicting that the only way the U.S. will get out of the vortex of rising debt is by cheapening the dollar massively.

In the long run, a country carrying trillions of dollars of debt and populated by an indebted populace cannot be trusted to fulfil its obligations. Sovereign default has always been a problem in the developing world - and even sometimes in Europe. The U.S., which has avoided crippling levels of debt, has never defaulted, and probably never will - technically. There's a much cleaner way to get away from debt.

A massive, rapid dollar inflation will effectively shrink the amount of debt carried by anyone who owes dollars. Thus, a 50% devaluation could drop the U.S. public debt from 66% of GDP to 33% of GDP, once prices adjust*. Borrowers would win big - half their debts would effectively be written off. Lenders would lose big - half their dollar assets would disappear.

This scenario has never developed because most of U.S. debt has been held by Americans, and there's a hefty deadweight loss associated with inflation. However, if the government keeps doling out trillions, and American debt (public and private) is held increasingly by China, Dubai, and Russia, the benefits of devaluation begin to outweigh its costs to Americans.

How would the government do this? Usually, the Federal Reserve likes to change the value of the dollar the classy way, by shifting interest rates and buying and selling Treasury bills. When that doesn't work, they've got to do it the Robert Mugabe way, by printing greenbacks. And in case you think they'd never do that - or it wouldn't work - check the news today. The Fed used the promise of printing money to achieve a 3% one-day drop against the Euro.

It may be 10 or 20 years before debts get so cripplingly large that the president starts to pressure the Fed into abandoning its non-inflationary mandate. In all likelihood, the bank will never have to respond: when holders of U.S. dominated debt (read: China) get antsy about the future prospects of the dollar, they'll dump them at a loss, causing a devaluation the same as if the Fed printed money. We might get a devaluation much sooner than we'd planned just because our creditors lose faith. In the short term, at least, this is a more likely scenario, similar in spirit to Krugman's 1979 effort "A Model of Balance of Payments Crises".

Whether it's a sneak attack by the printers at the Fed, or a pre-emptive strike by Beijing, look for the dollar to depreciate - a lot - in the coming decades.

* It's unlikely that the benefit of devaluation would be 1-for-1: the chaos, loss of trust in the dollar, and retaliation by other countries would eat up a big chunk of the gains.